Is Cereal Box Half Empty Or Half Full?

April 25, 1997|By Nancy Millman, Tribune Staff Writer.

Quaker Oats Co. chief William D. Smithburg, in announcing his retirement earlier this week, said he's preparing to leave his successor "the keys to a fast-moving machine," but some observers are concerned about what's under the hood.

Smithburg, Quaker's chairman, president and chief executive officer, boasted that the company--having shed its Snapple albatross--is chock-full of leading brands that are "outpacing the categories in which they compete."

In his remarks to analysts Wednesday, Smithburg insisted "the future looks very good." Some analysts, nevertheless, were disturbed by several aspects of the $5 billion company's business discussed in the recent quarterly report.

One red flag that popped up for analysts was in U.S. foods where, despite a 27 percent volume increase in cereals and 15 percent for Gatorade, profits dropped by 22 percent in the first quarter.

Cereals present a perplexing situation, not just for Quaker, but for the entire industry. Last year, all the major manufacturers cut prices by as much as 15 percent, which boosted overall volumes but cut profits.

Quaker, at the same time, expanded distribution of its bagged cereals, which are lower-priced to begin with.

Smithburg said the profit plunge was due to an unusual amount of advertising and marketing spending in the quarter. Some of that money went to promote the FDA-approved health claims about oats. Another portion went to marketing costs to push bagged cereals into more stores.

Steven Galbraith, an analyst at Sanford C. Bernstein in New York, finds this pattern disturbing.

"This is an appalling fact that investors haven't picked up on or understood," Galbraith said. "(Quaker) had a 27 percent volume gain in cereal and didn't have profits go up. It's by definition uneconomic.

"They're selling bagged cereal into new accounts--buying shelf space--which is costing them an arm and a leg, and the overall volume growth is masking a slowdown in volume in existing accounts."

Smithburg said the cereal industry should grow in the 2-to-3 percent range in the long term, but that bagged cereals will grow at a much faster rate. Quaker is No. 4 in cereals, with an 8 percent share of the U.S. market, 1 percent of that in bagged cereals.

The big, heavily advertised brands in the cereal business have been doing well since the industry price cuts, Smithburg said, while smaller brands are suffering.

Yet Quaker's pattern seems to be going against the trend.

"I have been concerned about the product mix and the changes in their cereal volumes," said John McMillan, an analyst at Prudential Securities. "They're selling more bags and fewer boxes. They're becoming less brand-oriented."

Another food area where Quaker faces a challenge is the grain-based snacks category, where Quaker sells granola bars and rice cakes. Quaker snacks were down 10 percent in volume for the first quarter.

Although this category remains profitable for Quaker--the company has a 77 percent market share--rice cake sales have steadily declined after a period of rapid growth a few years ago, Smithburg said.

"We need a constant flow of innovations to grow this category," he said.

The most powerful engine driving sales and profits at Quaker is Gatorade, and this weekend kicks off a new direction for the sports drink.

National advertising will promote Gatorade Frost, a product that targets people who may not be as athletic as the regular Gatorade guzzler. Smithburg has said he expects the new product to garner $100 million in sales in its first year.

"Gatorade clearly has substantial presence and they will get the initial distribution without any questions," said Michael Mauboussin, a food industry analyst at Credit Suisse First Boston in New York. "Gatorade's future continues to look very, very bright. The international story for Gatorade is going to kick in over the next three to five years."

Quaker's board of directors has begun a search for Smithburg's successor, and hopes to attract top-level candidates despite the flood of negative publicity related to Snapple that has plagued the company for more than two years.

Some names already have begun to circulate as possible successors. Leading the list is James Kilts, who resigned last month from Philip Morris Cos., where he was an executive vice president in charge of Kraft Foods Inc.

"Kilts obviously is a logical candidate," Mauboussin said. "There are lot of executives in packaged goods and consumer-related industries" who would be contenders, he said.